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Why the Absolute Price of a Stock Is Meaningless

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There is only one thing that matters in making money on stocks.

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During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn't worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price - by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.

Stock Profits Without Forecasting – by Edgar S. Genstein

These are two of the most important paragraphs I have encountered in 45 years of studying markets. DO NOT read them just once. Go off to a quiet spot that invites contemplation and READ THEM SEVERAL TIMES. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. My advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision, especially if your emotions reign.

Obviously, I agree with Mr. Genstein's advice, but over the years I have added a "twist" to his sage strategy. That twist has been to be a scale-up seller in select stocks that have appreciated when I think I should raise some cash. This does not mean I sell the entire position if I continue to find the fundamentals to be favorable. But scale selling partial positions accomplishes a number of things. Firstly, it allows capital gains to accrue to the portfolio (sometimes long-term capital gains and sometimes not). Secondly, it rebalances said stock position back towards the original portfolio weighting intended. Thirdly, it tends to give me the "margin of safety" mentioned in Benjamin Graham's book "The Intelligent Investor." To wit, this strategy allows me to hold some of my original investment positions until I "wish I would have sold them sooner."

I revisit this topic this morning after spending last week in Colorado speaking at several events and seeing institutional accounts. Unsurprisingly, most of the institutions have had a difficult time over the past few months. As one portfolio manager put it, "While we make money in one position we give more than that back in another." Indeed, since the "buying stampede" ended on January 26, it has been a market in which it has been pretty easy to lose money. For example, at the intraday high of January 26, the D-J Industrial Average (^DJI) traded at ~12842. Last Friday the senior index closed at ~13029 for a 12-week gain of 0.015%. Meanwhile, many individual stocks have fared far worse. As for retail investors, my presentations to them last week found most frozen like a deer in the headlights of a car buffeted by the recent decline and the negative "spin" from the media, so let me address the recent action.

Recall that we advised raising some cash following the cessation of the "buying stampede" in anticipation of a 5% - 8% pullback in the major averages. That said, our mantra was, "You can be cautious, but do not get bearish." Some took that "raise cash" advice, but most did not, imbibed by the Dow's 14.3% rally from mid-December, and its 23.4% rally since the October 4, 2011 "undercut low" that we actually recommended buying. Now, however, the Dow's 4.4% decline from its April 2 peak into its April 10 reaction low has brought back memories of last year's May to August angst, which lopped 17.6% off the Industrials. While the recent news backdrop is less appealing than that of October - February, it is still not a reason to believe we are going to see another May through June swoon of over 17%. Let's examine why.

In the last tactical bull market of October 2002 through October 2007 (60 months), there were nine such 4% or greater pullbacks, yet stocks traded higher after each correction. In the current tactical bull market of March 2009 to present (37 months), there have already been eleven 4% or greater pullbacks and each time stocks have also subsequently traded higher. Clearly the frequency of corrections/pullbacks has increased in the current cycle likely driven by memories of the Dow's 54.4% massacre between October 2007 into the March 2009 bottom that at the time we deemed would be similar to the "nominal" price-low of December 1974 (that was the "nominal" price low of that wide-swinging, trading-range 1965 – 1982 affair). More recently, we have likened last year's October 4 "undercut low" to the valuation-low that occurred in August 1982 since valuations last October were at levels not seen in decades. Whether we have begun a secular bull market like that of August 1982 – January 2000 is debatable, but we doubt last October's low will be violated.

Nevertheless, since the beginning of February there have been a number of gleanings that left us in cautious mode. The parade looks like this: An upside non-confirmation by the D-J Transports (^DJT), the small-caps also failed to confirm the upside with the Russell 2000 (IWM) subsequently experiencing a 7.5% decline, weakness in the market-leading Financial SPDR Fund (XLF), worsening Advance/Decline and New High/New Low figures, a 90% Downside Day on April 10, waning Buying Power, an exhaustion of the stock market's weekly internal energy, softening economic reports, and the list goes on. On the positive side: The stock market's daily internal energy has a full charge of energy, an 8.53% drop in the price of gasoline last week, an earnings reporting season that has so far seen 72% of companies beating estimates and 70% beating revenue estimates (more importantly, after two quarters of reducing guidance companies are now raising future earnings guidance), late Friday the IMF announced it has raised another $430 billion to be used if Euroquake worsens, a US dollar that looks like it is breaking down (read: a positive for stocks), and hereto the list goes on. All of this continues to leave us chanting, "You can be cautious, but do not get bearish!"

This week we will see more major companies reporting earnings. From our research universe, stocks that are favorably rated by our fundamental analysts and appear positive on our proprietary algorithms are: Brinker (EAT); Baidu (BIDU); PulteGroup (PHM); and Caterpillar (CAT).

The call for this week: For the past few weeks I have wrongly suggested that my sense is that the S&P 500 (SPY) will remain mired in the 1385 – 1425 consolidation zone. As paraphrased:

I think the SPX needs to convalesce in the 1385 – 1425 zone while the short-term overbought condition is alleviated and the market's internal energy is rebuilt. Interestingly, while my daily internal energy indicator now has more than a full charge of energy, the weekly energy indicator is nowhere near being fully recharged. The implication is that the downside should be contained, but the SPX is also not likely to breakout above 1425 without spending more time consolidating.... Importantly, all of the pullbacks in the SPX this year have been between 25 and 35 points. Accordingly, measuring from the recent reaction high of ~1419 produces a level of 1394 for a 25-point correction, and 1384 for a 35-pointer. Hence, anything more than a 45-point pullback would put the SPX below the bottom of our 1375 – 1385 support zone and suggest something has changed, potentially bringing into view the 1320 – 1340 zone.

Subsequently, the SPX dropped below that envisioned zone, yet has rallied back into the 1375 – 1385 zone, which has now become an overhead resistance level. And for these reasons, my firm counseled for caution before leaving for Colorado last week. Our advice was not to sell short, not to add to existing long positions, not to raise cash since we have already raised cash, but rather to sit tight because the downside should be contained in the 1320 – 1340 zone. Confidence that downside objective will be achieved grows if the April 10 intraday low of 1357.38 is violated. And this morning that pivot point looks like it is going to be tested with the preopening futures off some 14 points. Indeed, "The absolute price of a stock is unimportant. It is the direction of price movement which counts."
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